What Is a Prop Trading Firm & How Does It Work

Learn what a prop trading firm is, how prop firms work and what potential really lies in this type of business, along with the pros and cons.

Alexander Voigt

By Alexander Voigt | Updated October 17, 2023

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Do you wonder what a prop trading firm is and how it works? You might have heard of the potential that lies in this type of business, but you are still determining where to start.

If that’s the case, you’ve come to the best possible place.

What Is a Prop Trading Firm?

The term prop trading firm is the short version of proprietary trading firm. Those firms are a type of financial institution that grows their capital by buying and selling financial assets and securities such as stocks, futures contracts and forex pairs.

A prop firm’s team might first appear to have its strength due to professional traders who actively trade with the prop firm capital. However, in reality, the trading system developers, coders, math geniuses and analysts have the most responsible part within a classic prop firm.

However, the way prop firms are understood by the majority of traders and investors has recently shifted. Until 2020, a proprietary trading firm was primarily known as a company with offices in Chicago or New York.

Those companies hire finance professionals, IT geeks and computer science experts to gain an advantage in ever-changing markets and to give their traders access to proprietary technology that provides them with an edge in trading.

Prop Trading Firms Today

Since 2021, we have seen another young-generation type of prop firm arises, which dominates search results with search strings such as prop firm forex, best prop firm, instant funding prop firm, forex prop firm or futures prop firm.

In contrast to classic proprietary trading firms, those new firms are open to everyone, without job applications, interviews, and without the need to work in local offices.

Instead, now anyone can join a prop firm, where, in most cases, a trader first has to go through a trading challenge before finally earning a funded account. Those challenges can be 1-step challenges or 2-step challenges.

Some of the newer prop firms even specialize in instant funding accounts, where the trader directly gets access to the firm’s capital.

However, to participate in a trading challenge or join an instant funded account, the potential prop trader has to pay a participation fee to enter the challenge.

Once the challenge starts, the trader aims to reach the profit target while abiding by the rules set for the challenge. If he then makes it through the challenge, he earns a funded account. And this is the point where all prop trading firms are equal.

How Does a Prop Trading Firm Work?

A prop trader always aims to generate consistent profits by buying and selling securities, such as stocks, to help the prop firm gain capital at reasonable levels.

In exchange, the prop firm shares the profit made by the trader with the trader instead of paying him a fixed salary.

Within a prop trading firm, traders are responsible for different sectors in the market when they work as a team locally. In contrast, online and remote prop traders all work on their own, doing their best to make money trading the markets.

Since it’s in the interests of the proprietary trading firm to grow their wealth when letting traders trade their capital, they provide their traders with excellent education and knowledge.

The better educated their traders, the higher the chances of making significant progress in gaining the prop firms’ capital.

Education can include:

  • Web-based training,
  • In-house personalized training, or
  • Mentorship programs with senior traders who help junior traders find their success in the markets.

Why are Prop Trading Firms so Profitable?

Prop trading firms are so profitable because the most talented traders work for them by trading the prop firm’s capital. Strict money management rules ensure that the company capital is as seldom as possible at real risk. A senior manager monitors trading activity and closes positions if needed.

Superior technology is another beneficial factor for prop trading firms since high-end technologies and fast servers ensure that trade executions are always the best possible ones, helping make a reasonable overall profit, even if the profit per share or contract is minimal.

How to Join a Prop Trading Firm

1. Research and compare the best platforms for funded traders

Before you join a prop trading firm, make sure to do your due diligence during the process of finding the best firm that suits your needs the best by comparing and reviewing them. The separate guides about the best prop trading firms and best funded trader programs, along with scaling plan comparisons and the top 100 list of prop trading firms are the perfect starting points for research.

2. Use all training and educational material

Not all but many prop firms offer training and educational material, but if provided, use it to train yourself on how to use the prop platform, learn how to trade, learn about risk management, and if your prof firm offers no education, use either free resources or paid resources to expand your knowledge.

3. Find your edge by trading the financial asset that works best for you

While basic concepts like technical analysis and fundamental analysis are similar across all asset classes, make sure to specialize in trading the asset class you want to focus on. There are nuances of differences between trading stocks, options, futures or forex with a prop trading firm.

4. Plan your trading strategies and trade by the rules

You can’t win if you trade without a plan or strategy. So, before you place your first trade, make sure you trade based on your plan and trading strategy. Also, read the exact rule specifications of your prop firm.

If you trade against the rules, you will get disqualified if you trade a challenge-based approach. If you trade locally with a prop trading firm, your next talk with your supervisor won’t be that positive if you trade against the rules.

5. Have success and keep trading

Find your success in trading and keep going. As a prop trader, you need to achieve consistent profitable results since that’s what your baseline for your income will be. It is important to be focused and learn every day how to become better and better.

Conclusion

Prop trading firms are great alternatives to traditional brokerage firms. Instead of risking private capital, the trader trades the prop firm’s capital, with the chance of earning 90% or even more of the profits made, ready to be withdrawn to the bank account.

Benefits of Proprietary Trading Firms

  • The main benefit of prop trading is the limited risk. The fee that the trader pays to the prop firm is the maximum risk. Still, be aware some less legit prop firms out there have really hefty rule violation fees, which can ruin you.
  • I won’t list them here, but whenever you try to take a shortcut or if something sounds too good to be true, be careful.
  • Overall, it can be seen this way that a retail trader would typically open an account with, on average, $5,000 for trading or $25,000 for day trading and then lose most of it quickly during the learning phase.
  • The prop account limits the risk to the participation fee, and from there on, the prop firm takes the risk in case something goes wrong.
  • If a trader fails because he hits the drawdown limit or does not trade by the rules, then the attendance fee might be lost, but the private capital remains intact.
  • The basic concept of prop trading is a good one because, in real life, with your own funds, you should start in a simulated environment and only move to real money trading once successful.

Disadvantages of Proprietary Trading Firms

  • The most significant disadvantage of prop trading is the lack of transparency and chaotic rule sets of various prop firms.
  • How does it help if you can choose between 5 account types, 10 account sizes and any of them with different rules for getting funded?
  • I see it this way: the easier to understand the basic concept and the more transparent and easy-to-understand the rules, the better.
  • Another disadvantage of proprietary trading is that you can become addicted to it because it has some gamification components.
  • Overall, it is the same as trading a regular brokerage account.
  • You have to be goal-oriented, stay disciplined, have extensive knowledge, and know what you do to ensure consistent returns. Otherwise, the success will only be short-lived.

More on Prop Trading:

FAQ

How much do Prop Traders Make?

The amount of money you can make as a prop trader isn’t limited. But there is no minimum either. As a prop trader, you’ll seldom have a fixed monthly salary.

Instead, you earn a percentage of the profits you generate for the prop firm. So, if you have a profit split of 50/50 and make $10,000 in net profits, your prop firm will give you $5,000.

Are Prop Firms Legit?

There are legit prop firms, and other prop firms are scams. That’s similar to any other business in our world.

That’s why it is always a good idea to go with the market leaders that have high reputations, excellent ratings and proven company records.

As a prop trader, you want to make sure that you get paid, so focus on reviewing the payment terms.

What is the difference between a prop trading firm and a hedge fund?

The main difference is that a hedge fund invests its client’s capital. At the same time, prop trading firms only trade their company’s money.

Still, both prop firms and hedge funds use complex trading systems and advanced risk management techniques.

However, hedge funds primarily focus on shorting stocks longer term for hedging the risk, while prop firms use their algos to make profits in the short term.

Alexander Voigt
Alexander Voigt is the founder of DAYTRADINGz, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Business Insider, Investors, Capital and Forbes.